The third quarter begins with municipal portfolio managers divided on how to deal with uncertainty over tax and interest rate policy.
They are using a range of strategies – from maintaining an defensive approach with duration, coupon structure, credit quality, and income generation to taking on slightly higher credit risks or extending on the yield curve to get extra compensation. Some are just taking a wait and see approach.
“We are looking for more details on [President] Trump’s tax reform package,” said Michael Belsky, a financial advisor for Morgan Stanley Global Wealth Management.
“Credit risk has broadened out to more states,” he said. “Legal issues are clouding our perspective on the realities of revenue streams and the value of a general obligation.”
As a result, Belsky said the strength of current market prices will allow him to take some profits and sit on the sidelines “for a while.”
Other portfolio managers, like J.B. Golden, first vice president and portfolio manager at Advisors Asset Management, want to remain nimble in the third quarter to take advantage of opportunities.
He is maintaining his current strategy, which consists of a relatively defensive posture due to the expectation for higher rates, and is content keeping his duration at 85% of the Bloomberg Barclays 1-10 Year Municipal Blend Index benchmark that he aims to replicate.
The benchmark has a duration of 4.05 years, and Golden keeps his portfolio at 3.5 years -- which he feels is appropriate at a time when rates are rising and there is growing strong demand for municipals as the best option for risk-adjusted returns.
The strong demand for municipals has contributed to it being one of the most difficult times in his career to find paper, he said.
“It’s been a challenge to find good bonds in the market,” Golden, a 14-year industry veteran, said in an interview. “We’re not going to see any real improvement in supply any time soon,” he added, noting that volume is off roughly 19% from last year.
Year-to-date his defensive strategy has helped him outperform his benchmark, and he expects to do the same going forward.
“We are not staying ultra-short, but 85% let’s us be nimble and have enough liquidity as the market develops over the next few quarters,” he said. “Historically we have captured quite a bit of long-term yields by staying with short duration.”
He said he recently earned 65% to 70% of the 20-year yield by only going out 10 to 12 years -- “even in an environment where we haven’t seen a sharp move up.”
Michael Pietronico, chief executive officer at Miller Tabak Asset Management, recommends positioning duration slightly longer than the 1, 5, and 10-year Bloomberg Barlcays General Obligation indices and adjusting credit quality higher.
“While yield will always remain important when considering purchasing a bond, we sense a turn coming with regards to investor sentiment on credit risk,” Pietronico said. “It is easy to see why, as the economic data has been soft, and the Federal Reserve remains intent on raising borrowing costs further.”
He said a strategy of long duration and higher credit quality will act as “insurance against a policy mistake of overtightening credit by the Federal Reserve.”
“For municipal bond investors, the best time to prepare for a recession is before we enter one,” Pietronico advised.
Golden, on the other hand, suggests that a combination of buying 5% coupons that provide added protection against interest rate risk and dipping slightly in credit quality to make up for the lack of compensation in extending duration will reap rewards.
He is shifting downward in credit slightly, to single A paper from double-A paper, to capture some extra yield even if that means accepting some underperformance if rates fall.
Golden will continue to buy essential service paper, higher education, hospital, and airport bonds in the third quarter as he did earlier this year. He will also continue to be underweight in pension obligation bonds, and states like New Jersey, Illinois, and Connecticut, that have weathered severe fiscal stress lately.
“We don’t necessarily avoid GOs, but based on what the market is providing recently, we have more revenue than GOs,” he said.
With spreads “fairly tight” to post-credit crisis levels, Golden is willing to give up a little upside in order to maintain a defensive posture.
“We do see the municipal market more insulated from a rate hike than other markets,” he explained. “Even if we see a sideways market we feel our positioning and coupon stance will benefit us,” Golden said.
A more aggressive approach -- in terms of credit and duration -- is a strategy that will reap rewards as the second half begins, according to Peter Block, head of municipal research at Ramirez & Co.
“Curve positioning and credit selection are key to outperformance in 2017, given the potential for additional Fed rate increases and tax policy reform," Block wrote in a June 12 weekly municipal strategy report for the full-service investment bank, brokerage and advisory firm.
Block said he sees little reason to remain strictly defensive or significantly up in credit quality – and like Golden agrees that slightly dipping in quality can help performance going forward.
Sectors he prefers include dedicated tax, transportation, public power, and housing.
“As long as muni investors remain in a defensive posture, short-dated, high quality paper is likely to remain expensive and underperform longer durations,” Block wrote.
He supports extending duration as a strategy that will position investors for the eventual rise of long-term rates following a combination of ultra-low unemployment, slow but steady economic growth, wide rate hike expectations, and tax reform making municipals less attractive.
He believes the municipal market inside five years needs to cheapen on an absolute basis – and relative to Treasuries – to be attractive.
That belief leads to the use of a barbell strategy – currently allocating 30% on the short end and 70% intermediate to long maturities.
That barbell strategy has an effective duration of approximately nine years, given a significantly cheaper long-end and range-bound long rates, according to Block.
“We think a barbell portfolio strategy is optimal, including extension of effective portfolio to about 10 years [20-year average maturity] to both hedge downside risk [on the short end] and preserve income [on the long end],” Block added.
A neutral duration stance is in favor at BlackRock Inc., according to a June municipal market report published earlier this month by the Wall Street investment firm and money manager.
“We like flexible strategies that can navigate rate and policy uncertainty,” according to Peter Hayes, head of the municipal bond group, James Schwartz, head of municipal credit research, and Sean Carney, head of municipal strategy.
The team said it is extending curve bias to 20-plus years given waning tax policy risk, as investors remain yield-focused, favoring long-term and high-yield funds.
“Municipals posted a positive return in May as rates fell amid continued policy uncertainty in Washington, and supported by a favorable supply/demand dynamic,” the team wrote.
The third quarter should bring with it continued demand for municipals and more investment opportunities – especially on the long end of the curve given recent performance – according to the BlackRock team.
It cited the S&P Municipal Bond Index, which returned 1.32% in May and 3.49% year-to-date.
“Credit and long duration broadly outperformed as post-election fears continued to diminish and investors placed a premium on higher-yielding assets,” the analysts wrote. “Munis remain important portfolio diversifiers with a record of low volatility, high credit quality, and a tax-free income advantage,” BlackRock added.